What will a strong dollar bring?

John Mauldin believes we are in the opening act of a multi-year US dollar bull market. In his latest weekly letter, the commentator discusses some of the possible consequences of a long-term dollar rising trend.

First of all, if the dollar were to continue to rise and thus allow Europe and Japan to export their deflation to the US, it is not clear that the Fed would raise rates in June.

Close to 50 percent of sales and profits for the S&P 500 come from outside the US. A strong dollar will put a strain on those dollar-denominated profits.

It is particularly a problem for countries that are financed by the dollar carry trade. As long as the dollar is neutral or falling, that’s a good thing for dollar carry-trade investors.

If you are a Chinese businessman and you can borrow dollars and you believe that your government is going to make the yuan stronger over time, you will be able to pay back cheaper dollars and make the difference on the carry. But what happens if the yuan begins to fall? That trade unwinds swiftly and negatively. And it unwinds at a time that is particularly inconvenient for China.

It is not just China. Those dollars have filtered into every nook and cranny of the world; and now, if those trades are unwound, investors and most specifically hedge funds are going to have to buy dollars to unwind their trades. That will force the dollar ever higher against various currencies; and while any one currency is not significant enough to create a structural difference that can impact global trade, together they will have a significant effect.

There is a crisis brewing in emerging markets. Most of the world’s hedge funds and investors are on the wrong side of the dollar trade.

When – not if – there is a renewed crisis in Europe, the flight to safety is going to put pressure on the dollar and further downward pressure on US interest rates. While it is not altogether certain that China will have a major crisis – although reasonable economic historians would suggest that is the probable case – if it happens it will put further upward pressure on the dollar as a safe-haven currency.

We’re going to see a return of the bond bull market with a vengeance. Almost the entire world has hedged its bets for a rising interest-rate environment and assumes a benign dollar market. Almost no one expects a falling interest-rate environment, yet that is precisely what we will get if the dollar continues to rise and we have a crisis or two.

Writer, publisher and bestselling-author, John Mauldin offers his weekly perspective through the ‘Thoughts From the Frontline’ investment newsletter.

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